Chapter 6 of Tim Harford's The Undercover Economist

This is chapter six of the second edition of my book The Undercover Economist. When I published the new edition, by far the most substantial change was the addition of this chapter, which is all about the financial crisis.

Lots of people wrote to say they'd purchased the first edition and wondered whether they needed to buy the second edition too. This chapter gives you most of what’s changed, and that seems only reasonable.

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Book: The Undercover Economist

Related previous post: Tim Harford's PopTech talk: Preventing Financial Meltdowns

Greenlight Re Investor Day Video (May 2012)

Found via ValueWalk. David Einhorn enters the scene around the 24-minute mark.

Ron Johnson on CNBC: JC Penney Unveils New Concept Shop

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Iran sentences bank fraudsters to death

Maybe the judges read Jason Zweig’s article from over the weekend.

An Iranian court has sentenced four people to death for their role in a $2.8bn bank fraud, in a ruling that is set to intensify the battle between president Mahmoud Ahmadi-Nejad and conservative opponents ahead of a crucial election next year.

On Monday, Iran’s judiciary spokesman Gholam-Hossein Mohseni-Ejei said four people suspected of involvement in the fraud, the country’s biggest ever, had been sentenced to death, according to the semi-official ISNA news agency.

“The judge of the big corruption case has issued a death verdict for four out of the 39 suspects,” Mr Ejei said in his weekly press briefing, declining to name the four suspects. The others have been sentenced to life imprisonment and face jail terms as long as 25 years.

Bill Gross – August 2012 Investment Outlook: Cult Figures

The long-term history of inflation adjusted returns from stocks shows a persistent but recently fading 6.6% real return since 1912.

The legitimate question that market analysts, government forecasters and pension consultants should answer is how that return can be duplicated in the future.

Unfair though it may be, an investor should continue to expect an attempted inflationary solution in almost all developed economies over the next few years and even decades.

Rob Arnott on CNBC

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James Grant on CNBC

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Meredith Whitney on Bloomberg (video)

July 31 (Bloomberg) -- Meredith Whitney, founder and chief executive officer of Meredith Whitney Advisory Group, talks about the outlook for the banking industry and the U.S. economy. Whitney, speaking with Tom Keene and Scarlet Fu, also discusses the European sovereign debt crisis.

More Ray Dalio quotes

More Ray Dalio quotes from Jack Schwager’s book Hedge Fund Market Wizards. I think the last couple of long paragraph quotes below are especially important in regards to the current situation in the U.S.

“We don’t use stops. We trade approximately 150 different markets, where I am using the term market to also mean spread positions, as well as individual markets. However, at any given time, we probably have only about 20 or so significant positions, which account for about 80 percent of the risk and are uncorrelated to each other.”

…

“I don’t believe in reducing exposures when you have a losing position. I want to be clear about that. The only pertinent question is whether my being in a losing position is a statistically meaningful indicator of what the subsequent price movement will be. And it is not. For that reason, I don’t alter positions because they are losing.”

…

“The way we change our minds is a function of how that information passes through our decision rules. Our decision rules determine the position direction and size under the circumstances….It is 99 percent systematized. These systems evolve, however, as the experience we gain might prompt us to change or add rules. But we don’t make discretionary trading decisions on 99 percent of our individual positions.”

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On the origin of the Bridgewater system:

“Beginning around 1980, I developed a discipline that whenever I put on a trade, I would write down the reasons on a pad. When I liquidated the trade, I would look at what actually happened and compare it with my reasoning and expectations when I put on the trade. Learning solely from actual experience, however, is inadequate because it takes too much time to get a representative sample to determine whether a decision rule works. I discovered that I could backtest the criteria that I wrote down to get a good perspective of how they would have performed and to refine them. The next step was to define decision rules based on the criteria. I required the decision rules to be logically based and was careful to avoid data mining. That’s how the Bridgewater system began and developed in the early years. That same process continued and was improved with the help of many others over the years.”

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When asked if the rules get revised:

“They are sometimes revised. For example, we used to look at how changes in the oil price affected countries. Between the first oil shock and the second oil shock in the 1970s, crude oil was discovered in the North Sea, and the U.K. went from being a net importer to a net exporter. That event prompted us to change how we configured the decision rule that related to oil prices so that when the mix of export and import items changed, the rule changed.”

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When asked how he was able to perform well in 2008:

“Our criteria for trading in a deleveraging had already been established because we had previously studied other leveragings and deleveragings. Our analysis included both inflationary deleveragings, such as Germany in the 1920s and Latin America in the 1980s, and deflationary deleveragings, such as the Great Depression of the 1930s and Japan in the 1990s. I had also directly experienced the deleveragings in Latin America and Japan. We felt that if these sort of big events had happened before, they could happen again. We also believed that fully comprehending these events was important to understanding how economies and markets worked….In short, by knowing how deleveragings occur, we could monitor the appropriate factors, and by understanding the cause-and-effect relationships in a deleveraging, it was not difficult to be well positioned in 2008.”

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When asked about the current economic situation, Dalio mentioned the importance of distinguishing between countries that are debtors and those that are creditors, and countries that can print and those that cannot print money. Debtor countries that can’t print money will experience deflationary depressions. In regards to those debtor countries such as the U.S. that can print money:

“Those that can print money, such as the United States, can alleviate the deflation and depression pressures by printing money. However, the effectiveness of quantitative easing will be limited because the owners of the bonds that are purchased by the Fed will use the money to buy something similar; they are not going to use it to buy a house or a car. In addition, fiscal stimulus will be very limited because of the reality of the political situation. So it is unlikely that we will have effective monetary policy or effective fiscal policy. That means we will be dependent on income growth, and income growth will be slow—maybe about 2 percent per year—because income growth is usually dependent on debt growth to finance buying, and I don’t expect any significant private credit growth. A growth rate of 2 percent is not sufficient to meaningfully lower the unemployment rate. There is a risk that if the economy deteriorates, we won’t have any effective tools for reversing the situation. The current situation is analogous to being in a recession and not being able to lower interest rates.”

“The best policy would be to spread out the problems over a long period of time so that nominal interest rates stay below nominal growth rates….You do it through a combination of monetary and fiscal policies that produce enough government spending to make up for the reduction in private sector spending to keep the economy from contracting. Avoiding an unmanaged contraction is essential in order to maintain social and political order. At the same time, there needs to be well thought-out debt restructurings because we can no longer allow our debts to rise faster than our incomes, and we need to gradually lower them….it is very important that the fiscal spending is used for investments that generate returns that are greater than their costs. We can’t afford to waste money.”

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Related links:

An In-Depth Look at Deleveragings

How the Economic Machine Works

Should Crimes of Capital Get Capital Punishment? – By Jason Zweig

Overheard in midtown Manhattan at the lunch hour:

“Another day, another financial scandal. New regulations, prosecution, getting hauled up in front of Congressional hearings – nothing seems to stop it.”

“Maybe we need to try something more drastic.”

“Like what?”

“Well, there’s always the death penalty.”

Unfortunately, that’s been tried, too – and found wanting. Financial criminals throughout history have been beaten, tortured and even put to death, with little evidence that severe punishments have consistently deterred people from misconduct that could make them rich.

The history of drastic punishment for financial crimes may be nearly as old as wealth itself.

Wait - The useful art of procrastination

Found via The Big Picture.


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Related book: Wait: The Art and Science of Delay - By Frank Partnoy

FT Interview: Mohamed El-Erian (video)

The global economic outlook is very worrisome, says Mohamed El-Erian, chief executive of Pimco, the global bond asset manager. He tells John Authers, long view columnist, that we are likely to see a continuing overdependency on central bank policy, which will prove largely ineffecitve for promoting growth.

Ray Dalio quotes

Ray Dalio quotes from Jack Schwager’s book Hedge Fund Market Wizards:

Original lesson learned after the U.S. went off the gold standard in 1971:

“I learned that currency depreciations and the printing of money are good for stocks. I also learned not to trust what policy makers say. I learned these lessons repeatedly over the years.”

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On the Fed's power over the market:

“I learned not to fight the Fed unless I had very good reasons to believe that their moves wouldn’t work. The Fed and other central banks have tremendous power. In both the abandonment of the gold standard in 1971 and in the Mexico default in 1982, I learned that a crisis development that leads to central banks easing and coming to the rescue can swamp the impact of the crisis itself.”

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“In trading you have to be defensive and aggressive at the same time. If you are not aggressive, you are not going to make money, and if you are not defensive, you are not going to keep money.”

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Correlation and diversification:

“There are ways to structure your trades so that you can produce a whole bunch of uncorrelated bets. You have to start with your goal. My goal is that I want to trade more than 15 uncorrelated assets. You are just telling me your problem, and it’s not an insurmountable problem. I strive for approximately 100 different return streams that are roughly uncorrelated to each other. There are cross-correlations that enter into it, so the number works out to be less than 100, but it is well over 15. Correlation doesn’t exist the way most people think it exists. People think that a thing called correlation exists. That’s wrong. What is really happening is that each market is behaving logically based on its own determinants, and as the nature of those determinants changes, what we call correlation changes. For example, when economic growth expectations are volatile, stocks and bonds will be negatively correlated because if growth slows, it will cause both stock prices and interest rates to decline. However, in an environment where inflation expectations are volatile, stocks and bonds will be positively correlated because interest rates will go up with higher inflation, which is detrimental to both bonds and stocks. So both relationships are totally logical, even though they are exact opposites of each other. If you try to represent the stock/bond relationship with one correlation statistic, it denies the causality of the correlation. Correlation is just the word people use to take an average of how two prices have behaved together. When I am setting up my trading bets, I am not looking at correlation; I am looking at whether the drivers are different. I am choosing 15 or more assets that behave differently for logical reasons. I may talk about the return streams in the portfolio being uncorrelated, but be aware that I’m not using the term correlation the way most people do. I am talking about the causation, not the measure.”

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“I think that one of the greatest problems that plagues mankind is that people are always saying, “I think this, and I think that,” when there is a high probability they are wrong. After all, to the extent that there is strong disagreement about an issue, a lot of the people must be wrong. Yet most of them are totally confident they are right. How is that possible? Imagine how much better almost all decision making would be if people who disagree were less confident and more open to trying to get at the truth through thoughtful discourse.”

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On Bridgewater's decision-making process:

“Our decision-making process is to determine the criteria by which we make decisions in the market. Those criteria—I call them principles—are systematized. These principles determine what we do under different circumstances. In other words, we make decisions about the criteria we use to make decisions. We don’t make decisions about individual positions. For any trading strategy, we can look back at when it won, when it lost, and under what circumstances. Each strategy develops a track record that we deeply understand and then combine in a portfolio of diversified strategies. If a strategy is not performing in real time as expected, we can reevaluate it, and if we agree it is desirable, we might modify our systems. We have been doing this for 36 years. Over the years, we develop new understandings, which we continually add to our existing understandings.”

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“….we test our criteria to make sure that they are timeless and universal. Timeless means that we look at a strategy during all different times, and universal means that we look at how a strategy worked in all different countries. There is no reason why a strategy’s effectiveness should change in different time periods or when you go from country to country. This broad analysis through time and geography gives us a unique perspective relative to most other managers. For example, to understand the current U.S. zero interest rate, deleveraging environment, we need to understand what happened a long time ago, such as the 1930s, and in other countries, such as Japan in the postbubble era. Deleveragings are very different from recessions. Aside from the ongoing deleveraging, there are no other deleveragings in the U.S. post–World War II period.”

John Mauldin: Gambling in the House?

The latest scandal du jour seems to be about what is now called LIBORgate. But is it a scandal or is it really just business as usual? And if we don’t know which it is, what does that say about how we organize the financial world, in which $300-800 trillion, give or take, is based on LIBOR? This is actually just the second verse of the old song about derivatives, which is a much larger market. Which of course is a problem that was not solved by Dodd-Frank and that has the potential to once again create true havoc with the markets, whereas LIBOR can only cost a few billion here and there. (Sarcasm intended.)

The problem is the lack of transparency. Why would banks want to reveal how much profit they are making? The last thing they want is transparency. This week I offer a different take on LIBOR, one which may annoy a few readers, but which I hope provokes some thinking about how we should organize our financial world.

Hussman Weekly Market Comment: No Such Thing as Risk?

The enthusiasm of investors about central-bank interventions has reached a pitch that is already well-reflected in market prices, and a level of confidence that with little doubt, investors will ultimately regret. In the face of this enthusiasm, one almost wonders why nations across the world and throughout recorded history have ever had to deal with economic recessions or fluctuations in the financial markets. The current, widely-embraced message is that there is no such thing as an economic problem, and no such thing as risk. Bernanke, Draghi and other central bankers have finally figured it out, and now, as a result, economic recessions and market downturns never have to happen again. They just won’t allow it, printing more money will solve everything, and that’s all that any of us need to understand. And if it doesn’t solve everything, they can just keep doing more until it works, because there is no consequence to doing so, and all historical evidence to the contrary can finally, thankfully, be ignored. How could anyone ever have believed, at any point in history, that economics was any more complicated than that?

Unfortunately, the full force of economic history suggests a different narrative. Up to a certain point, which seems to be about 100-120% debt-to-GDP, countries can pull themselves from the brink of sovereign crisis through a combination of austerity (spending reductions), restructuring (putting insolvent financial institutions into receivership and altering the terms of unworkable private and public debt), and monetization (relief of government debt through the permanent creation of currency). Austerity generally reduces economic growth (and corporate profits) in a way that delivers less debt reduction benefit than expected, restructuring is often stimulative to growth because good new capital no longer has to subsidize old misallocations, but is politically contentious, and monetization of bad debt produces clear but often quite delayed inflationary pressures. None of these choices is simple.

Moreover, once countries have created massive deficits and debt burdens beyond about 120% of GDP – typically not to accumulate of productive assets and investments that service that debt, but instead to fund consumption, bail out insolvency, and compensate labor without output – austerity produces further economic depression, restructuring becomes disorderly and produces further economic depression, and attempts at monetization tend to be hyperinflationary.

Europe is fast approaching the point at which every solution will be disruptive, and remains urgently in need of debt restructuring, particularly across its banking system. It is a pleasant but time-consuming fantasy to believe that governments that are already approaching their own insolvency thresholds can effectively bail out a banking system that has already surpassed them. To expect the ECB to simply print money to solve the sovereign debt problems of Spain, Italy and other members is also dangerous. This hope prevents these nations from taking receivership of insolvent institutions now, and allows them to continue to operate in a way that threatens much more disorderly outcomes later.

Steven Romick’s Q2 Letter

As bottoms-up value investors – but not to the point of being blind to the 30,000-foot view – we believe one ignores the macro at great peril. Therefore, in this letter we will share some of the big-picture considerations that are integral to our investment process. We’re left with the view that the world will continue to see bouts of high volatility and that the level of economic growth in developed economies will probably be less than most expect. We do not believe the markets have priced such expectations adequately.

TEDx Talk - David MacKay: A reality check on renewables

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Related previous post: Sustainable Energy - Without the Hot Air with David MacKay

Related book: Sustainable Energy - Without the Hot Air

TEDx Talk - Garth Lenz: The true cost of oil

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Bridgewater: Spanish Collateral Is Running Out

Via Zero Hedge (I'd love to read the full Daily Observation piece, if anyone has access to it):

We estimate that the Spanish banking system only has a few hundred billion euros left in eligible collateral. That means that some of the weaker banks are likely already getting close to a point where their collateral is exhausted. (We think this reality is the reason why we are seeing a number of legal changes in Spain that look like an attempt to scrounge up a bit more capital). if Spanish banks run out of ECB collateral, then the Spanish central bank would likely need to turn on its own ELA. The potential magnitude of such an operation would dwarf the nationalized money printing to date.

Spanish balance sheets can probably support about €800 billion of borrowing from the ECB. Between the ECB and privately secured funding, mostly foreign interbank, Spanish banks are already borrowing about €500 billion, and if private secured funding was pulled, this borrowing and related collateral could be shifted to the ECB. So we think about the remaining capacity to borrow as the total collateral borrowing capacity (€800 billion) less what is pledged to both the ECB and private lenders (€500 billion), or about €300 billion. However, this almost certainly overstates Spanish banks' collateral cushion because there are strong banks such as BBVA and Santander that probably have ample capacity and weaker banks that are likely much closer to being tapped out.

The attempt to manage the imbalances among the Euroland economies is an extremely dangerous highwire act, and to the extent that monetary policies diverge to serve individual countries' needs, the further capital flows will likely go in the opposite direction.

Steve Keen on Sky News

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Dick Kovacevich on CNBC

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Leithner Letter No. 151-154

Link to: Leithner Letter No. 151-154: 26 July - 26 October 2012

Oilprice.com’s interview with Mike “Mish” Shedlock

Link to: Oilprice.com’s interview with Mike “Mish” Shedlock

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I don’t necessarily agree with everything he says, but this is an interesting interview. If you substitute ‘undervalued stocks’ in place of ‘gold’ in his recommendation of being about 70-80% in cash and 20-30% in gold, then you’d get about the allocation we currently have for separate accounts within Chanticleer Investment Partners (for more information, go HERE and HERE), an entity I’m involved with that launched a few months ago. Although I like holding some cash in case a great opportunity arises, I don’t particularly liking holding as much cash as we do today, but I feel it is the proper course of action in today’s environment. My feelings today largely reflect the two quotes below:

“Some argue that holding significant cash is gambling, that being less than fully invested is akin to market timing. But isn’t a yes or no decision the crucial one in investing? Where does it say that investing means always buying something, even the best of a bad lot? An investor who can’t or won’t say no forgoes perhaps the most valuable tool available to investors.” –Seth Klarman (excerpt from 2004 letter)

“Another important point I try to teach my students is that you have to consider not only what your opportunity set is right now, but also what opportunities you may be forgoing later by investing now. If your opportunity set is not that great right now, maybe you should wait another 6 to 12 months before becoming fully invested.” –Joel Greenblatt (as quoted in the book Hedge Fund Market Wizards)

Amazing photos 2012

Found via @farnamstreet. There are some pretty incredible pictures.

Link to: Amazing photos 2012

Ray Dalio quote

“The type of thinking that is necessary to succeed in the markets is entirely different from the type of thinking that is required to succeed in school….Most school education is a matter of following instructions—remember this; give it back; did you get the right answer? It teaches you that mistakes are bad instead of teaching you the importance of learning from mistakes. It doesn’t address how to deal with what you don’t know. Anyone who has been involved in the markets knows that you can never be absolutely confident. There is never a trade that you know you are right on. If you approach trading that way, then you will always be looking at where you might be wrong. You don’t have a false confidence. You value what you don’t know. In order for me to form an opinion about anything involves a higher threshold than if I were involved in some profession other than trading. I’m so worried that I may be wrong that I work really hard at putting my ideas out in front of other people for them to shoot down and tell me where I may be wrong. That process helps me be right. You have to be both assertive and open-minded at the same time. The markets teach you that you have to be an independent thinker. And any time you are an independent thinker, there is a reasonable chance you are going to be wrong.” –Ray Dalio (as quoted in Hedge Fund Market Wizards)

Meredith Whitney on CNBC

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Capital gains - American profits have been high but the trend may not last

NEVER mind the divide between Main Street and Wall Street. The big gap at the moment is between workers and corporations. Although unemployment remains stubbornly high and wage rises are hard to come by, corporate profits are taking a larger share of American GDP than before the financial crisis (see chart).

America stands out from the pack, one reason why its stockmarket has been outperforming the rest of the developed world. In both continental Europe and Japan, earnings per share are well below their November 2007 levels.

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Why have profits been so high, despite the fragility of the economy? American firms were very quick to sack workers after the crisis started. But there is also a longer-term explanation, based on the weakened power of labour after the entry of countries like China into the global employment market. Companies have been able to move production offshore and to resist demands for wage increases from workers in their domestic market.

But even if capital is lording it over labour, a second mechanism ought to bring corporate profits down. A high return on capital should encourage a wave of investment. The resulting expansion in capacity should increase competition and reduce returns. But that has yet to happen: companies are still hoarding cash.

There are three potential explanations for this cash mountain. The first is that executives are worried about excessive regulation. American bosses in particular may be waiting for a possible change of administration after the presidential election in November.

The second is that firms are reluctant to invest in the face of weak demand. Domestic consumers have been under pressure from austerity and higher commodity prices; the euro-zone crisis and a slowdown in developing economies is weighing on export prospects. Companies may have milked all they can from productivity improvements. The irony here is that a high share of GDP for profits automatically results in a low share for wages and thus may eventually be self-limiting—a positively Marxist outcome.

The third explanation for cash hoarding is the most intriguing. Andrew Smithers of Smithers & Co, a consultancy, suggests incentives may be to blame. Managers are motivated by share options and share prices are driven by changes in earnings per share. Spending cash on share buy-backs boosts earnings per share immediately, whereas a capital-investment programme may actually reduce earnings in the short term.

Marc Faber on Capital Account

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Value Matters: Predictability of Stock Index Returns

Found via World Beta.

Abstract:

The aim of this paper is twofold: to provide a theoretical framework and to give further empirical support to Shiller's test of the appropriateness of prices in the stock market based on the Cyclically Adjusted Price Earnings (CAPE) ratio. We devote the first part of the paper to the empirical analysis and we show that the CAPE is a powerful predictor of future long run performances of the market not only for the U.S. but also for countries such us Belgium, France, Germany, Japan, the Netherlands, Norway, Sweden and Switzerland. We show four relevant empirical facts: i) the striking ability of the logarithmic averaged earning over price ratio to predict returns of the index, with an R squared which increases with the time horizon, ii) how this evidence increases switching from returns to gross returns, iii) moving over different time horizons, the regression coefficients are constant in a statistically robust way, and iv) the poorness of the prediction when the precursor is adjusted with long term interest rate. In the second part we provide a theoretical justification of the empirical observations. Indeed we propose a simple model of the price dynamics in which the return growth depends on three components: a) a momentum component, naturally justified in terms of agents' belief that expected returns are higher in bullish markets than in bearish ones; b) a fundamental component proportional to the log earnings over price ratio at time zero. The initial value of the ratio determines the reference growth level, from which the actual stock price may deviate as an effect of random external disturbances, and c) a driving component ensuring the diffusive behaviour of stock prices. Under these assumptions, we are able to prove that, if we consider a sufficiently large number of periods, the expected rate of return and the expected gross return are linear in the initial time value of the log earnings over price ratio, and their variance goes to zero with rate of convergence equal to minus one. Ultimately this means that, in our model, the stock prices dynamics may generate bubbles and crashes in the short and medium run, whereas for future long-term returns the valuation ratio remains a good predictor.

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Related previous post: Does the Shiller-PE Work in Emerging Markets?

Mother lion takes on deadly crocodile to give cubs safe swim across river

Found via Naked Capitalism.

Link to: Mother lion takes on deadly crocodile to give cubs safe swim across river

1932 summer stock market rally

As described in two entries by Benjamin Roth in The Great Depression: A Diary:

SEPTEMBER 1, 1932

The month of August just ended has been the lowest point so far in the depression for all kinds of business and professional men. The heat has been severe and all kinds of activity are at a complete standstill. The stock market on the contrary tripled its value during August in one of the quickest climbs ever witnessed. I believe this also established a record. Nobody seems to know even yet why the stock market went up because business has gotten worse instead of better.

SEPTEMBER 7, 1932 

…Some comparison between stock prices between July and September follows: Aluminum Co. of Am. 25-85; Sheet & Tube 4 to 27; Bethlehem Steel 7 to 30; AT&T 70 to 120; U.S. Steel 22 to 50; Western Union 13 to 50; United Aircraft 7 to 30. Most of railroads are 400% higher now than in July although railroad business continues to get worse.

Bridgewater/Dalio approach

Short description using a few excerpts from Jack Schwager’s book Hedge Fund Market Wizards:

“The flagship fund uses the relatively rare combination of a fundamentally based systematic approach. (Most hedge funds that are fundamentally based use a discretionary approach, and most hedge funds that use systematic approaches base them on technical input.)….Dalio describes his approach as “timeless and universal.” He believes an economic model should encompass multiple times and countries. Bridgewater employs a fundamentally based computer model that incorporates trading rules gleaned from both Dalio’s four decades of market observations as well as Bridgewater’s analysis of markets going back hundreds of years and spanning a broad range of developed and emerging economies….The idea that the same fundamentals would have different implications under different circumstances and environments is an essential component of Dalio’s analytical thinking. As a result, categorization is an important tool for both conceptualizing problems and finding solutions.”

Earnings surprises, price reaction and value - By Aswath Damodaran

Professor Damodaran also attaches a link to his Apple valuation spreadsheet at the end of his post.

The earnings season is upon us and each company’s earnings announcement is eagerly awaited, traded upon and talked about. For widely followed companies like Apple, the obsession with what the next earnings report will deliver overwhelms any sensible assessment of what it means for the company. But is this obsession merited? Do earnings announcements have significant effects on value? If so, why? More importantly, can you make money off earnings announcements?

Greenlight Q2 Letter

Found via Market Folly.

On the first day of winter, lulled by the security of the European Central Bank’s Long Term Refinancing Option (LTRO), the bears went into hibernation. They stirred on the first day of spring and then, just one day into the second quarter, they woke up in earnest and the market’s relentless rise came to an abrupt end. April marked the beginning of a decline that continued steadily for the next two months. With many possible trouble spots coming back into view, the market can’t seem to focus on more than one crisis at a time. Once again, Europe’s woes took center stage.

Rogers: Why Hendry and Edwards are wrong on China

Interesting. I could see a little back and forth banter coming from this.

Jim Rogers has dismissed fears of a hard landing in China, saying slowing growth is simply proof the authorities are managing the economy as they intended.

Rogers’ bullish views on China’s long-term economic prospects place him at odds with well-known China bears Hugh Hendry of Eclectica and SocGen’s Albert Edwards.

“Hugh has been dead wrong about China for three years now and China has not collapsed as he predicted, loudly, verbally and widely,” said Rogers.

“Albert has been bearish on everything for a long time. So if you are telling me he is bearish on China and bullish on everything else that would be different. But no, he is bearish on everything, including you, me and Mother Teresa.”

Keith Bradsher on Charlie Rose

Discussing China.

Link to: Keith Bradsher on Charlie Rose

Colm O’Shea on position size

From the book Hedge Fund Market Wizards (largely different from how most value investors operate, but interesting nonetheless):

“First, you decide where you are wrong. That determines where the stop level should be. Then you work out how much you are willing to lose on the idea. Last, you divide the amount you’re willing to lose by the per-contract loss to the stop point, and that determines your position size. The most common error I see is that people do it backwards. They start with position size. Then they know their pain threshold, and that determines where they place their stop.”

Watsa’s Fairfax Becomes RIM’s Biggest Shareholder

Research In Motion Ltd. (RIMM) shareholder Fairfax Financial Holdings Ltd. (FFH) almost doubled its stake in the BlackBerry maker, making it RIM’s biggest investor and offering a vote of confidence to the ailing Canadian company.

Fairfax, an insurer run by Toronto-based investor Prem Watsa, owns 51.9 million RIM shares, according to a regulatory filing today. It held 26.8 million shares as of April 1, according to data compiled by Bloomberg. The company raised its stake to 9.9 percent, worth about $351 million.

Does the Shiller-PE Work in Emerging Markets?

Found via Mebane Faber.

We test the reliability of the Cyclically Adjusted PE (CAPE) or Shiller PE as a forecasting and valuation tool for 35 countries including emerging markets. We find that the Shiller-PE is a reliable long-term valuation indicator for developed and emerging markets and we use the indicator to predict real returns on local equity markets over the next five to ten years.

Five Guys Burgers: America's Fastest Growing Restaurant Chain

Jerry Murrell says it’s time for lunch, and he knows exactly the place to go. The 68-year-old founder and chief executive of the brightest star in the restaurant industry jumps into his blue Ford pickup parked at the company’s headquarters, a redbrick building in an unremarkable office park hard by Interstate 95 in Lorton, Va. He negotiates the back roads of the town—once home to a 10,000-inmate correctional facility—to a strip mall, which, of course, has one of his restaurants, Five Guys Burgers and Fries. He ambles in and, without glancing at the sparse menu he personally designed, orders a burger and some fries.

The staff—a gaggle of twentysomethings—is jumpy, deferentially calling him “Mr. Murrell.” They have reason to be nervous. For the past two days this store, along with a dozen others, has been involved in an intense “fry calibration” class led by Murrell’s third-eldest son, Chad, who has drilled them on the proper mix of starch, water and temperature needed to create the perfect french fry (Murrell believes cooking is about feel; there are no timers in his restaurants). “Fries are much harder than burgers,” says Murrell. “We work day and night on them, all the damn time.”

Such are the problems of being the fastest-growing restaurant chain in the U.S., which has doubled its number of stores since 2009. Murrell initially had the idea for a higher-quality burger restaurant back in 1986, as a way to keep his family nearby and, perhaps, make a little money on the side. He has succeeded grandly on both counts. He, his wife and all five of his sons (the “five guys”) work for the company, live within 20 minutes of one another and vacation together every summer. And the money? The private burger chain has 1,039 stores open in the U.S. and Canada, and another 1,500 committed to build. Since 2006 the company has grown 792%, according to Technomic, a Chicago-based food industry research group. (Its nearest competitor is Jimmy John’s, which grew 241% over the same period and has 1,329 stores.) Five Guys, with a mix of company-owned (200) and franchised (839) stores, has sold out all of its franchise rights in North America. The entire chain, including sales at the franchises, will surpass $1 billion in revenues this year, up from $950 million in 2011. Corporate revenues, from company-owned stores and franchise fees, will be roughly $275 million, with a cash flow of $50 million.

The seven Murrells each own equal shares of the ­company, which add up to 75%. Miller Investment Management, a boutique Philadelphia firm, owns 20% of the company, and a few of Murrell’s school buddies own the remaining 5%. The company is worth an estimated $500 million, which puts the Murrells’ stake somewhere around $375 million. Not a bad return on an initial ­investment of less than $70,000.

The 10 Best, and Worst, Times in History to Invest (on 12/31 of a given year)

On a related point to the chart included in the link below, the current CAPE is about 21.5.

Let’s say you just decided whether to invest once a year, and your timeframe was for the next 10 years.  What have been the 10 best, and worst years to invest since 1871? (10 year real returns, compounded).

How to kill the euro without causing a financial apocalypse

The £250,000 Wolfson challenge to find the least damaging way for countries to abandon the euro has been won by economist Roger Bootle and his research firm Capital Economics.

The victorious entry, titled 'Leaving the euro: A Practical Guide', focuses on the best way for a weak member like Greece to manage an orderly exit from the single currency.

It concludes that although the departure of one or more eurozone members would create winners and losers, the overall outcome would be positive for the growth and prosperity of the rest - and the wider world economy.

Bootle and his team beat competition from more than 400 initial entrants to take the Wolfson Economics Prize, which was set up by Next boss Lord Wolfson and is the second-largest award to an economist after the Nobel Prize.

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If you own euros, you may want to check the serial numbers in case one of the runner-up submissions comes to pass: HERE

The Crisis in 1000 words—or less - By Steve Keen

URPE–The Union for Radical Political Economics–is holding a Summer School for the Occupy movement, and as part of that invited papers that explained the crisis in 1000 words or less (so that they can be printed on one double-sided sheet).  Here’s my effort in somewhat less than 1,000 words (though with 2 figures).

Why We're Driven to Trade – By Jason Zweig

Most of the folks who say buy and hold is dead don't talk much about their long-term returns. Instead, they stress how they have done recently, a tactic that for many potential clients has the same irresistible appeal as the last couple of pulls on a slot machine.

The solution to short-term thinking isn't to bash yourself in the forehead with a hammer, of course. But you can use your brainpower to your advantage.

Every investing decision you make should be the result of a deliberate process.

Start by creating a checklist of criteria that every stock or fund must meet before you buy or sell. Make sure you never buy or sell an investment exclusively because its price has gone up or down. In advance, list three reasons having nothing to do with price that would justify buying or selling.

After you sell, track the returns of those investments you sold, after you sold them, to see if they did better than whatever you bought in their place.

You don't have to trade like mad just because the people who grab headlines hold stocks for a few minutes or seconds at a time. Knowing the limits of your knowledge is the highest form of intelligence.

Berlin, IMF To Refuse Fresh Aid for Greece

Found via The Big Picture.

Greece has fallen behind with its budget cuts and is asking lenders for more time to meet the conditions of the 130 billion euro aid package. But that would require fresh help of up to 50 billion euros, SPIEGEL has learned. Neither Berlin nor the IMF are prepared to make that money available.

BIOLOGY AT THE SPEED OF LIGHT: A Talk by J. Craig Venter

Found via Simoleon Sense.

Link to: BIOLOGY AT THE SPEED OF LIGHT

Hussman Weekly Market Comment: Extraordinary Strains

Just weeks after the enthusiasm over Europe’s plan to plan for the possibility of using the European Stability Mechanism to bail out Spanish banks, the subtle technicality – that direct bailouts would make all of Europe’s citizens subordinate to even the unsecured bondholders of Spain’s banks – has predictably deflated that enthusiasm. On the growing recognition that addressing Spain’s banking problem will mean taking those banks into receivership, wiping out unsecured debt (much of which unfortunately was sold to unknowing Spanish savers as secure “savings” vehicles), and having the Spanish government sort out the damage, Spanish 10-year debt plunged to new lows last week (see chart below), and Spanish yields hit fresh Euro-crisis highs. At the same time, interest rates in Germany, Finland, Holland, Denmark and Switzerland all moved to negative levels looking 2-5 years out. The world is paying these governments to lend money to them, because the only way to acquire other default-free, non-commodity assets is to hire armored trucks and secure vaults to take delivery of physical currency. This set of conditions is not normal or sustainable, and indicates extreme credit market strains in Europe.

John Mauldin: The Lion in the Grass

I have been captivated by the concept of the seen and the unseen in economics since I was first introduced to the idea. It is a seminal part of my understanding of economics, at least the small part I do grasp. The idea was first written about by Frédéric Bastiat, who was a French classical liberal theorist, political economist, and member of the French assembly. He was notable for developing the important economic concept of opportunity cost. He was a strong influence on von Mises, Murray Rothbard, Henry Hazlitt, and even my friend Ron Paul. He was a strong proponent of limited government and free trade, but he also advocated that subsidies (read, stimulus?) should be available for those in need, "... for urgent cases, the State should set aside some resources to assist certain unfortunate people, to help them adjust to changing conditions."

Today we'll explore a few things we can see and then try to foresee a few things that are not so obvious. This is a condensation of a speech I gave earlier this afternoon in Singapore for OCBC Bank, called "The Lion in the Grass." The simple premise is that it is not the lions we can see that are the problem; but rather, in trying to avoid them, it is often the lions hidden in the grass that we stumble upon that become the unwelcome surprise.

Seneca quote

"Each day acquire something that will fortify you against poverty, against death, indeed against other misfortunes as well; and after you have run over many thoughts, select one to be thoroughly digested that day." -Seneca, Letters from a Stoic

Jason Mraz Unplugged in a London Borders (2006)

Kind of cool to see a talented musician off-the-cuff like this. This took place in February 2006.


Link

Seneca quote

"It is not the man who has too little, but the man who craves more, that is poor. What does it matter how much a man has laid up in his safe, or in his warehouse, how large are his flocks and how fat his dividends, if he covets his neighbour's property, and reckons, not his past gains, but his hopes of gains to come? Do you ask what is the proper limit to wealth? It is, first, to have what is necessary, and, second, to have what is enough." -Seneca, Letters from a Stoic

Former IMF Economist Says He's ‘Ashamed’ Of Links To Fund

The full letter is posted HERE.

An International Monetary Fund economist who said he is leaving the institution wrote that he is “ashamed” of being associated with it and criticized it for what he said was a failure to send warnings about the global financial crisis and the European debt turmoil. 

“The consequences include suffering -- and risk of worse to come -- for many including Greece, that the second global reserve currency is on the brink, and that the fund for the past two years has been playing catch-up and reactive roles in the last-ditch efforts to save it,” according to the letter written by Peter Doyle, who worked as a division chief in the European department.

Bridgewater Q2 Letter: Outlook and Markets Discussion

Via Zero Hedge.

The developed world remains mired in the deleveraging phase of the long-term debt cycle. The European deleveraging has been badly managed and is escalating, bringing Europe closer to either a debt implosion or a monetization and currency collapse. The impact of the European deleveraging has spread to the emerging world through diminished capital flows which have weakened their growth rates and undermined their asset prices. In the US, the deleveraging is progressing in a more orderly fashion but continues to weigh on the economy's ability to grow without the monetary support of the Fed. Our studies of deleveragings have proven to be invaluable through this period (let us know if you would like a copy of the expanding library). Because the dynamics of deleveragings are understandable and observable throughout history, one can reasonably assess the nature of their outcomes over time. But because highly-indebted systems that are in deleveragings are also inherently unstable, the timing of discrete events is always highly uncertain (e.g., the shift from austerity to monetization, an exit from the euro, etc.). Through these studies we have continued to refine the indicators we use to measure how the forces of deleveraging are impacting various economies and markets, and we continue to make the relevant adjustments to our investment process that both allow us to anticipate these shifts and to control our risks through the unpredictable twists and turns.

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Related links:

An In-Depth Look at Deleveragings

How the Economic Machine Works

Jack Schwager on gold

From Hedge Fund Market Wizards:

“Many years ago, when I was a commodity research director, I would totally ignore gold production and consumption in analyzing the market. I would base any price expectation entirely on such factors as inflation and the value of the dollar because those are the factors that drive psychology. I always found it ridiculous when other analysts would write lengthy reports on gold analyzing such things as annual production prospects and jewelry usage. Annual production and consumption of gold are always a tiny fraction of supply, maybe around 1 percent, so who cares how much they change. It has nothing to [do] with the price.”

Brainstorm Tech: One-on-One with Marc Andreessen

One-on-One with Marc Andreessen from Fortune Conferences and Fortune Conferences on FORA.tv

Brainstorm Tech Dinner Debate: Schmidt and Thiel smackdown

Dinner and Debate with Eric Schmidt and Peter Thiel from Fortune Conferences and Fortune Conferences on FORA.tv

Walter Isaacson interviews Don Graham, Laura and Tim O'Shaughnessy

Social Media from Fortune Conferences and Fortune Conferences on FORA.tv

Ron Johnson interview from Brainstorm Tech

One-on-One with Ron Johnson from Fortune Conferences and Fortune Conferences on FORA.tv

East Coast Asset Management's Q2 Letter

Found via Market Folly.

In our Q2 letter you will find an update on our portfolio and general market observations. Each quarter we highlight one component of our investment process - this quarter we discuss the “compounder” category, and specifically how we differentiate a great business from those of lesser quality. Included in this section is a representative example of a compounder business we recently added to our portfolio.

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Excerpt:

The hierarchy of thinking can be broken down into four levels. The first level is data—simple facts and figures. The second is information. Information is data that has been gathered and organized and can be used as a reference tool. The third level is knowledge. This can be described as information that we have digested and now understand. The mind has collected information and put it into context and has arrived at the know-how.

The fourth and final level is wisdom. Wisdom is often indistinguishable from knowledge. Wisdom is the proper use of knowledge - the know-why. Wisdom is a deep understanding of universal truths – the realization of people, things, events or situations, resulting in the ability to apply perceptions, judgments and actions in keeping with this understanding. Wisdom is the comprehension of what is true, coupled with the optimum judgment as to action. Knowledge can be described as doing things right, where wisdom is doing the right things.

The world is in the early innings of a tectonic paradigm shift toward a knowledge-based economy. Just as the developed world has transitioned in the past from an agricultural economy to an industrial economy to post-industrial/mass production economy, this transition will produce an irreversible shift in the global state of mind. With this change, some businesses will lead, evolve, and prosper and others will cease to exist. “In times of change, learners inherit the earth, while the learned find themselves beautifully equipped to deal with a world that no longer exists.” [Eric Hoffer quote]

Seth Klarman on the Painful Decision to Hold Cash

Excerpt from Seth Klarman’s 2004 letter, but words that I think ring very true today as well.

It wouldn’t be overstating the case to say that investors face a crisis of low returns: less than they want or expect, and less than many of them need. Investors must choose between two alternatives. One is to hold stocks and bonds at the historically high prices that prevail in today’s markets, locking in what would traditionally have been sub-par returns. If prices never drop, causing returns to revert to more normal levels, this will have been the right decision. However, if prices decline, raising prospective returns on securities, investors will experience potentially substantial mark to market losses, thereby faring considerably worse than if they had been more patient.

The alternative is to remain liquid, defy the steady drumbeat of performance pressures, and wait for the prices of at least some securities to drop. (One doesn’t need the entire market to become inexpensive to put significant money to work, just a limited number of securities.) This path also involves risk in that there is no certainty whether or when this will occur; indeed, securities prices could rise further from today’s lofty levels, making the decision to hold cash even more painful. Meanwhile, holding out for better returns involves a (potentially lengthy) period of very low (albeit certain) positive returns available from today’s short-term U.S. Treasury instruments.

While we have strong suspicions, it cannot be said with certainty which path will prove wisest. What is clear is that just about everyone will choose the former one. Those in the investment business compete on the basis of short-term, relative (not absolute) investment performance, and prefer to follow the herd (at the price of assured mediocrity) rather than stand apart (risking severe underperformance). From a business perspective, how much better to be actively deploying capital, even if the investments are mediocre, than to be stalled in neutral; the employees keep busy, while the clients confuse decisions with diligence, activity with insight, and a fully invested posture with a worthwhile portfolio.

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Some argue that holding significant cash is gambling, that being less than fully invested is akin to market timing. But isn’t a yes or no decision the crucial one in investing? Where does it say that investing means always buying something, even the best of a bad lot? An investor who can’t or won’t say no forgoes perhaps the most valuable tool available to investors. Charlie Munger, Warren Buffett’s long-time partner, has counseled investors, “Look for more value in terms of discounted future cash flow than you’re paying for. Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor.”